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Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable
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Remember Jaws? In 1975, the small town of Amity was on the eve of the Fourth of July weekend, a time of celebration of the founding of this marvelous country. But just before the celebration was about to begin, a vicious shark attack occurs. Concerned about losing the money from the holiday tourist trade, the mayor and townsfolk ignore the warnings to keep people out of the water. But then after another shark attack, and yet another, the town’s leadership finally grasps the peril, but not before more disasters occurred.
Jaws, writes John Whitehead, wasn’t just a simple story about sharks. Instead, it was a social commentary about how a love of money can blind us to averting preventable disasters.
Fast forward to the financial meltdown of 2008 and what do we see? America again was celebrating. The economy was booming. Everyone seemed to be getting wealthier, even though the warning signs were everywhere: too much borrowing, foolish investments, greedy banks, regulators asleep at the wheel, politicians eager to promote home-ownership for those who couldn’t afford it, and distinguished analysts openly predicting this could only end badly. And then, when Lehman Bros fell, the financial system froze and world economy almost collapsed. Why?
The root cause wasn’t just the reckless lending and the excessive risk taking. The problem at the core was a lack of transparency. After Lehman’s collapse, no one could understand any particular bank’s risks from derivative trading and so no bank wanted to lend to or trade with any other bank. Because all the big banks’ had been involved to an unknown degree in risky derivative trading, no one could tell whether any particular financial institution might suddenly implode.
Since then, massive efforts have been made to clean up the banks, and put in place regulations aimed at restoring trust and confidence in the financial system. But the result in terms of dealing with the basic problem, according to a terrific article by Frank Partnoy and Jesse Eisinger in The Atlantic entitled “What’s Inside America’s Banks?” is failure.
Another global financial crisis is on the way
Financial reform didn’t work. Banks today are bigger and more opaque than ever, and they continue to trade in derivatives in many of the same ways they did before the crash, but on a larger scale and with precisely the same unknown risks.
Ignoring warning signs has inevitable consequences. We ignored them before and we saw what happened. We can say this with virtual certainty: if we continue as now and ignore them again, the great white shark of a global financial meltdown will gobble up the meager economic recovery and make 2008 look like a hiccup.
We can’t say when this will happen. We can’t say which bank or which particular instrument will trigger the debacle. What we can say with virtual certainty is that if we continue as now is that it will happen. Because the scale of the trading is larger, and because the depleted government treasures are not well placed for another huge bailout, the impact will be worse than 2008.
Today’s financial scandals are mere sideshows
Thus the biggest risk we face is not the stories of repeated wrongdoing by the banks that are still making headlines, such as:
The world’s scariest story: trading in derivatives
Bad as these scandals are and vast as the money involved in them is by any normal standard, they are mere blips on the screen, compared to the risk that is still staring us in the face: the lack of transparency in derivative trading that now totals in notional amount more than $700 trillion. That is more than ten times the size of the entire world economy. Yet incredibly, we have little information about it or its implications for the financial strength of any of the big banks.
Moreover the derivatives market is steadily growing. “The total notional value, or face value, of the global derivatives market when the housing bubble popped in 2007 stood at around $500 trillion… The Over-The-Counter derivatives market alone had grown to a notional value of at least $648 trillion as of the end of 2011… the market is likely worth closer to $707 trillion and perhaps more,” writes analyst Jenny Walsh in The Paper Boat.
“The market has grown so unfathomably vast, the global economy is at risk of massive damage should even a small percentage of contracts go sour. Its size and potential influence are difficult just to comprehend, let alone assess.”
The bulk of this derivative trading is conducted by the big banks. Bankers generally assume that the likely risk of gain or loss on derivatives is much smaller than their “notional amount.” Wells Fargo for instance says the concept “is not, when viewed in isolation, a meaningful measure of the risk profile of the instruments” and “many of its derivatives offset each other”.
However as we learned in 2008, it is possible to lose a large portion of the “notional amount” of a derivatives trade if the bet goes terribly wrong, particularly if the bet is linked to other bets, resulting in losses by other organizations occurring at the same time. The ripple effects can be massive and unpredictable.
Banks don’t tell investors how much of the “notional amount” that they could lose in a worst-case scenario, nor are they required to. Even a savvy investor who reads the footnotes can only guess at what a bank’s potential risk exposure from the complicated interactions of derivatives might be. And when experts can’t assess risk, and large bets go wrong simultaneously, the whole financial system can freeze and lead to a global financial meltdown.
In 2008, governments had enough resources to avert total calamity. Today’s cash-strapped governments are in no position to cope with another massive bailout.
Wells Fargo: is this good bank “extremely safe”?
The article in The Atlantic clarifies what’s going on by exploring what’s going on inside what is arguably the safest and most conservative bank: Wells Fargo [WFC].
Last year, I had written an article about the case for considering Wells Fargo as a “a good bank”.
Wells does what banks are supposed to do: take deposits and then lend the money back out. Interest margin drives half its revenues. Fees from mortgages, investment accounts and credit cards generate the other half. ‘I couldn’t care less about league tables,’ says Wells CEO Stumpf. ‘I’m more interested in kitchen tables and conference room tables.’ By operating a bank like a bank, the article says, Stumpf has at once made Wells exceedingly profitable—for 2011 the bank’s net income jumped 28% to $15.9 billion, on $81 billion in revenue—and extremely safe. The value of Wells Fargo’s shares is now the highest of any U.S. bank: $173 billion as of early December 2012.
Wells Fargo: large scale trading in derivatives
But among the startling disclosures in the article in The Atlantic from examining the footnotes in its most recent annual report are:
A lower circle of financial hell: “special purpose entities” redux
Ever heard of “variable interest entities” aka VIEs? If not, you are not alone. They are phenomena that reside in what The Atlantic calls “an even lower circle of financial hell” than proprietary trading. They are basically a new label for “special-purpose entities” i.e. the infamous accounting devices that Enron employed to hide its debts. These deals were called ‘off-balance-sheet’ transactions, because they did not appear on Enron’s balance sheet.
The article likens variable interest entities to “a horror film, which the special-purpose entity has been reanimated… The problem is especially worrisome at banks: every major bank has substantial positions in VIEs.”
As of the end of 2011, Wells Fargo, the “extremely safe bank”, reported “significant continuing involvement” with variable-interest entities that had total assets of about $1.5 trillion. The ‘maximum exposure to loss’ that it reports is much smaller, but still substantial: just over $60 billion, more than 40 percent of its capital reserves. The bank says the likelihood of such a loss is ‘extremely remote.’ As The Atlantic comments: “We can hope.”
Worse: “Wells Fargo… excludes some VIEs from consideration, for many of the same reasons Enron excluded its special-purpose entities: the bank says that its continuing involvement is not significant, that its investment is temporary or small, or that it did not design or operate these deals. (Wells Fargo isn’t alone; other major banks also follow this Enron-like approach to disclosure.)… The presence of VIEs on Wells Fargo’s balance sheet ‘is a signal that there is $1.5 trillion of exposure to complete unknowns.’”
Other banks are even riskier
Thus it turns out that Wells Fargo isn’t so much an “extremely safe” bank in absolute terms but rather a bank that isn’t doing as much risky stuff as the other big banks. “One reason Wells Fargo is trusted more than other big banks is that its notional amount of derivatives is comparatively small… It’s just somewhat less involved in derivatives than other banks.” The amount of its ‘notional involvement’ in proprietary trading in derivatives amounts to “only” about half the size of the entire US economy.
By contrast, at the end of the third quarter of 2012, JPMorgan had$72 trillion in notional amount on its books—almost five times the size of the U.S. economy, or about the size of the entire world economy.
But even at the lower levels of trading by Wells Fargo, the numbers are so large that they put Wells Fargo’s seemingly immense capital reserves—$148 billion—as a mere drop in an ocean of potential losses.
Wells Fargo declined to answer questions from the journalists from The Atlantic. Their response to requests for clarification was to suggest re-reading the unhelpful sections of the annual report. They also declined to answer: “How much money would Wells Fargo lose from these trades under various scenarios?”
Ironically, Jamie Dimon has been proven right when he made light of the $6 billion trading loss at JPMorgan last year. Compared to the scale of these potential losses, and the financial crisis that lies ahead, a loss of $6 billion is merely a “tempest in a teacup.”
How does Wells Fargo make money?
The Atlantic also finds worrying issues in how Wells Fargo does make money. Scouring through Wells Fargo’s annual report, seemingly safe conservative categories turn out to involve proprietary trading:
Meanwhile in this world of shell games and mind-boggling numbers, big losses can go unremarked. Buried in a footnote on page 164 of Wells Fargo’s annual report is the admission of a trading loss of $377 million loss on trading derivatives related to certain CDOs,” or collateralized debt obligations went unremarked, because of bigger losses for instance at JPMorgan. “Wells Fargo’s massive CDO-derivatives loss was a multi-hundred-million-dollar tree falling silently in the financial forest. To paraphrase the late Senator Everett Dirksen, $377 million here and $377 million there, and pretty soon you’re talking about serious money.”
Specialists and hedge funds as much in the dark as the public
Public confidence in banks is now at a record low. According to Gallup, in the late 1970s, around 60 percent of Americans said they trusted big banks “a great deal” or “quite a lot.” In June 2012, less than 25 percent of respondents told Gallup they had faith in big banks.
But it’s not just public confidence. Specialists are equally bewildered. The Atlantic cites:
Wall Street doesn’t trust big banks
Wall Street already reflects its distrust of the big banks. Even after a run-up in the price of bank stocks this fall, many remain below “book value,” which means that the banks are worth less than the stated value of the assets on their books. This indicates that investors don’t believe the stated value, or don’t believe the banks will be profitable in the future—or both.
The reality is that even an ostensibly simple and “extremely safe” bank like Wells Fargo impossible to understand. Every major bank’s financial statements have some or all of these problems; many banks are much worse.
Regulation hasn’t worked
In the wake of the recent financial crisis, the government has moved to give new powers to the regulators who oversee the markets. But the net result of the effort to regulate the big banks is almost as stupefying as the amounts of money involved. Draft Basel III regulations total 616 pages. Quarterly reporting to the Fed required a spreadsheet with 2,271 columns. 2010’s Dodd-Frank law was 848 pages and required regulators to create so many new rules (not fully defined by the legislation itself) that it could amount to 30,000 pages of legal minutiae when fully codified. What human mind can possibly comprehend all this?
Complex accounting rules have thus made the problem worse. Clever bankers, aided by their lawyers and accountants, find ways around the intentions of the regulations while remaining within the letter of the law. Because these rules have grown ever more detailed and lawyerly—while still failing to cover every possible circumstance—they have had the perverse effect of allowing banks to avoid giving investors the information needed to gauge the value and risk of a bank’s portfolio.
What to do: more clarity and actual sanctions
Some experts propose that the banking system needs more capital. Others call for a return to Glass-Steagall or a full-scale breakup of the big banks. These reforms could help, but none squarely addresses the problem of opacity, or the mischief that opacity enables.
The Atlantic suggests that a starting point is “to rebuild the twin pillars of regulation that Congress built in 1933 and 1934, in the aftermath of the 1929 crash. First, there must be a straightforward standard of disclosure for Wells Fargo and its banking brethren to follow: describe risks in commonsense terms that an investor can understand. Second, there must be a real risk of punishment for bank executives who mislead investors, or otherwise perpetrate fraud and abuse.”
The Atlantic argues that these two pillars don’t require massively complicated regulation. The straightforward disclosure regime that prevailed for decades starting in the 1930s didn’t require extensive legal rules. Nor did vigorous prosecution of financial crime.
However it does require political will-power. The decision not to prosecute UBS for criminal tax fraud in 2009, when a smaller bank was so prosecuted, sends a clear signal that the large banks are not only too big to fail and too complex to manage. They are also too big to punish.
The Atlantic suggests a grand bargain: “simpler rules and streamlined regulation if they subject themselves to real enforcement.”
A paradigm shift in banking
Rules and penalties can only take us so far. Nothing significant is likely to change until the dynamic of the financial sector changes. The SEC and the courts can pursue the banks with court cases and penalties, but they will always be confronted with time-wasting legal defenses, as well as time lags between the invention of new ways to fleece customers and the discovery and proof of those methods.
The financial sector is in effect an extreme example of the shareholder value theory run amok. Pursuit of profit not only undermines the banks themselves and ultimately the global economy as a whole.
Regulation and enforcement will only work if it is accompanied by a paradigm shift in the banking sector that changes the context in which banks operate and the way they are run, so that banks shift their goal from making money to adding value to stakeholders, particularly customers. This would require action from the legislature, the SEC, the stock market and the business schools, as well as of course the banks themselves.
Ultimately, change is for the banks’ own good. Without it, investors will continue to worry about which bank will be the next Lehman Brothers, while the rest of us can only brace ourselves for the next inevitable financial cataclysm.
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